LIBOR Probably Moving out of the UK, But Where to is Missing the Point

Quote: EU regulators published guidelines on Thursday to stop banks rigging Libor and other market benchmarks as an interim measure before a more far-reaching EU law comes in. The draft law, to be published in a few weeks, would propose shifting the supervision of Libor from London to Paris.

And: The principles were drawn up with the European Banking Authority provide a framework for administrating, calculating, publishing and submitting quotes for compiling all benchmarks.

The guidelines also require benchmark providers to have contingency plans if data for compiling the index dries up. Another new element is that data used to compile a benchmark should represent the underlying asset, such as a commodity or interest rates and based on “observable transactions entered into at arm’s length”.

The central problem with London InterBank Offered Rate is that the interbank lending market has ceased to exist. No bank or other monetary institution would dream of offering a loan to another bank. That must be especially true after Cyprus where depositors lost a great deal of money – and even Putin eventually just shrugged his shoulders.

Interest Rate Fixed In Relation To The LIBOR

On the other hand a vast number of loans have their interest rate fixed in relation to the LIBOR and to change literally millions of individual loan agreements is probably not practically possible. This would lead to endless legal complications for eons to come.

The trick is to change not the word LIBOR, but the substance – as the rigging scandal shows there IS no substance to LIBOR at present (and not very likely to be in the future). This will bring the interest rate under the ESMA’s control, which is probably preferable to no control what so ever.

This raises the next issue: How is the ESMA going to coordinate the fixing of the interest rate with the ECB? The operative word is obviously “contingency plan”! This leads straight back to the ECB. Ultimately the liquidity originates from the ECB, as they extend credit to cash strapped banks – if the ECB does not, then the CB’s all over Europe does. As it is there is tons of liquidity deposited in the CB’s.

Take Denmark – yet again – as an example:

There is a net deposit in the CB of 200 bio. DKK rather constantly. The cash need for the settlement of transactions is about 40 bio. DKK. This leaves an abundance of 10% GDP in cash with no proper employment. On the other hand the large banks are liquidity starved, so they are extended credit with good loans as collateral giving a gross position of 250 bio. DKK in deposits and 50 bio. DKK in loans.

I should have said was, as during this last month about 35-40 bio. DKK of the loans to banks have had their collateral changed into business bonds where debtors bypass the banks and approach the major investors directly. The resulting interest rate has been reported to be 3½ % for a maturity of 5-7 years. This is in stark contrast to an interest between ½ % and ¾% for German sovereign bonds – provided you can get them – which you can’t. There is only about 100 bio. EUR of them in “circulation”. The Danish CB has flat out stopped quoting interest rate on sovereign bonds half a year ago.

Now this gives the LIBOR discussion a different dimension.

As said business bonds are of prime quality – otherwise the CB would not have accepted them as collateral – they carry an interest rate of 3½% for a maturity of approximately 6 years. But reasonably comparable sovereign securities have no (to all intends and purposes) interest rate.

How on earth are you going to set an interest rate that does not exist (and the 3½% is partly determined from an interbank rate)?

The solution seems to be to take the banks out of the loop and dismiss them from their more or less self-appointed task of converting excess liquidity to longish term capital need. Because that is precisely what happened this last month! The net deposits in the CB are roughly unaffected!

LIBOR Scandal

The fallout is:

a) Banks will regret they ever took the cheap credit from the CB’s as it will cost them the loans they make money on. That was the trick behind the LIBOR scandal: To jack up the interest rate the banks debtors had to pay. The notion that banks can ever get recapitalised seems a bad joke. Their earning margin is steadily shrinking at the same time their balances are bloating with bad debt.

b) The attempt by Danske Bank A/S (CPH:DANSKE) (PINK:DNSKY) to rob the small depositors demanding a “subscription” on top of no interest and other arbitrary fees is going to back-fire – big time. The EU-Commission chairman Brarosso is forwarding a proposal to make it a right for an EU-citizen to have a no frills positive balance account free (or nearly free) of charge. The idea is stupid in the first place, as small depositors do not contribute much to bank balances anyhow (as we saw on Cyprus) – the large deposits in banks come from investors like pension funds with no credible securities to buy.

c) Everybody knows – or they are incredibly naive – that the reason for these low interest rates is that the banks are stuffed to the gills with non-performing loans. That is a euphemism for the ultimate foul word of finance: LOSS. The reality is that banks have no “equity” – so the notion that investors are just anxious to pay for these losses is also not credible. When investors accept negative interest rates on their deposits in CB’s (which is actually worse than that as there is a slight inflation).

Conclusion:

The EU through various organs is trying to live without banks.

The ECB might just as well set an arbitrary interest rate and the entire interest structure, as it is more than unlikely there will ever emit an intelligible word from the banks. But it will give the investors and businesses a sort of a guideline to what a business investment should yield.

There will be no macroeconomic effect, as with such low interest rates investment is largely unaffected by official interest rates.